2. U.S. Export Transaction U.S. Import Transaction Balance of Payments Flexible Exchange Rates The Market for Currency Determinants of Exchange Rates Fixed Exchange Rates Exchange Controls and Rationing International Exchange Rate Systems Recent U.S. Trade Deficits Key Terms EXCHANGE RATES, THE BALANCE OF PAYMENTS, AND TRADE DEFICITS 36 C H A P T E R

3. U.S. Export Transaction U.S. Import Transaction Balance of Payments Flexible Exchange Rates The Market for Currency Determinants of Exchange Rates Fixed Exchange Rates Exchange Controls and Rationing International Exchange Rate Systems Recent U.S. Trade Deficits Key Terms BALANCE OF PAYMENTS (the sum of all the transactions that take place between a country’s residents and the residents of all foreign nations, ie. all the payments a nation receives from foreign countries and all the payments it makes to them). Comprised of 3 Accounts: 1) Current Account- summarizes US trade in currently produced goods and services; comprised of: a) Balance on Goods & Services- difference between a country’s imports and exports of goods. b) Balance on Current Account – balance on G & S plus + Net inv. Income + Net Transfers i)Net Inv. Income- difference between the interest and dividend payments foreigners paid the US for use of exported capital and what the US paid foreigners for imported foreign capital. ii)Net Transfers- foreign aid, pensions paid to US citizens living outside US. 2) Capital Account- summarizes the purchase or sale of real or financial assets and the flows of monetary payments that accompany them. a) Balance on Capital Account- Current Account plus foreign purchases of assets in US and US purchases of assets abroad.

4. U.S. Export Transaction U.S. Import Transaction Balance of Payments Flexible Exchange Rates The Market for Currency Determinants of Exchange Rates Fixed Exchange Rates Exchange Controls and Rationing International Exchange Rate Systems Recent U.S. Trade Deficits Key Terms BALANCE OF PAYMENTS cont’d 3) Official Reserves Account- quantities of foreign currencies held by a foreign govt. drawn on to make up any net deficit in the combined current and capital accounts (sort of like when you dip into your savings account to pay for a special purchase) Balance of Payments- must always sum to zero, ie. always in balance; Deficits & Surpluses occur in the Current and Capital Account -Check out this explanationthis explanation

5. U.S. Export Transaction U.S. Import Transaction Balance of Payments Flexible Exchange Rates The Market for Currency Determinants of Exchange Rates Fixed Exchange Rates Exchange Controls and Rationing International Exchange Rate Systems Recent U.S. Trade Deficits Key Terms parachuteCurrent Account parachute factory Capital Account [If you bought a parachute from a factory in Germany–Current Account] [If you bought a parachute factory in Germany – capital investment, so Capital Account ] Current Account [trade in currently produced goods, svcs, net investment & transfers] goods exports (1) U.S. goods exports……………………………………………$+ 683 goods imports (2) U.S. goods imports………………………………………..…...-1,167 goodsvisibles$-484 (3) Balance on goods [visibles]………..…………………………………………..$-484 exports of services (4) U.S. exports of services [shipping, insur., tourists, bank.] +289 imports of services (5) U.S. imports of services…………………………………..…….- 240 services [invisibles]+ 49 (6) Balance on services [invisibles]………………………..................................+ 49 goods and services-436 (7) Balance on goods and services…………………………………….…………..-436 Net investment (8) Net investment income (income earned for svc of exported capital [money] [Profits received from overseas investment (interest, dividends, and rents)] ……………………………………………………………………… - 12 Net transfers (9) Net transfers (gifts given to the indivs, foreign aid, pensions, etc.)…… - 56 Balance on current account-504 (10) Balance on current account…………………………………………………... -504 Capital Account Capital Account [buying/selling of physical & financial assets[stocks/bonds] Foreign purchases of assets (11) Foreign purchases of assets in the U.S. …………………..+645 U.S. purchases of assets abroad (12) U.S. purchases of assets abroad……………….……………-145 Balance on capital account+500 (13) Balance on capital account…………………………………………….…..….+500 Official Reserves Account Exported $4 bil. of foreign money+4 (14) Official reserves (Exported $4 bil. of foreign money)…….. +4 $0 +exported stock of foreign moneydollars enter U.S. Official Reserves: + = exported stock of foreign money (so dollars enter U.S.) - imported stock of foreign moneydollars exit U.S. - = imported stock of foreign money (so dollars exit U.S.) -4 -4

6. U.S. Export Transaction U.S. Import Transaction Balance of Payments Flexible Exchange Rates The Market for Currency Determinants of Exchange Rates Fixed Exchange Rates Exchange Controls and Rationing International Exchange Rate Systems Recent U.S. Trade Deficits Key Terms

7. U.S. Export Transaction U.S. Import Transaction Balance of Payments Flexible Exchange Rates The Market for Currency Determinants of Exchange Rates Fixed Exchange Rates Exchange Controls and Rationing International Exchange Rate Systems Recent U.S. Trade Deficits Key Terms Goods exports…………….. Goods imports…………….. + U.S. Goods export………………….…….…..+$100 - U.S. Goods imports……………………………...-80 + U.S. Service exorts…………………………...…+40 - U.S. Service imports………………………….…-90 + Net Investment income………………..……….+20 - Net transfers………………………………….…..-15 + Capital inflows to the U.S…………………..….+40 - Capital outflows from the U.S……………….…-10.- Official reserves ………………......................…..-5 1. The U.S. is experiencing a balance on goods(deficit/surplus)of ($10/$20/$30 ). Goods exports (____) – goods imports (____) = $_____ 2. The U.S.’s balance on goods and services is a (deficit/surplus) of $30 billion. (goods/services exports(____) – goods/services imports (____) = ______) 3. The U.S.’s balance on the current account is (+25/-$25). [Balance on g/s(___) + net investment income(___) + net transfers(___) = C.A.(___)]. 4. The balance on the capital account is a (surplus/deficit) of ($20/$30/$40). [capital inflow(___) – capital outflow(___) = _______] 5. The U.S. is experiencing a balance of payments (surplus/deficit) of $5. [don’t include official reserves here] 6. The “official reserves account indicates the U.S. (imported/exported) $5 billion of its stock of foreign reserves. +exportenter [A + here means we will export a stock of foreign money($’s will enter U.S.] - importexit [A - here means we will import a stock of foreign money($’s will exit U.S.]

8. U.S. Export Transaction U.S. Import Transaction Balance of Payments Flexible Exchange Rates The Market for Currency Determinants of Exchange Rates Fixed Exchange Rates Exchange Controls and Rationing International Exchange Rate Systems Recent U.S. Trade Deficits Key Terms Goods exports…………….. Goods imports…………….. + U.S. Goods export………………….…….…..+$100 - U.S. Goods imports…………………………….. - 80 + U.S. Service exports…………………………... +40 - U.S. Service imports………………………….… - 90 + Net Investment income………………..……….+20 - Net transfers………………………………….…. - 15 + Capital inflows to the U.S…………………..….+40 - Capital outflows from the U.S……………..…. - 10. - Official reserves ………………......................…. - 5 surplus $20 1. The U.S. is experiencing a balance on goods(deficit/surplus)of ($10/$20/$30 ). $100$80$20 Goods exports ($100) – goods imports ($80) = $20. 2. The U.S.’s balance on goods and services is a (deficit/surplus) of $30 billion. $140$170-$30 (goods/services exports($140) – goods/services imports ($170) = -$30) -$25 3. The U.S.’s balance on the current account is (+25/-$25). (-$30)($20)(-$15)(-$25)]. [Balance on g/s(-$30) + net investment income($20)+ net transfers(-$15)=C.A.(-$25)]. 4. The balance on the capital account is a (surplus/deficit) of ($20/$30/$40). ($40)(-$10)$30 [capital inflow($40) – capital outflow(-$10) = $30] 5. The U.S. is experiencing a balance of payments (surplus/deficit) of $5. [don’t include official reserves here] 6. The “official reserves account indicates the U.S. (imported/exported) $5 billion of its stock of foreign reserves. +exportenter [A + here means we will export a stock of foreign money($’s will enter U.S.] - import exit [A - here means we will import a stock of foreign money($’s will exit U.S.] 20 -30 G/S Curr.Acct - 25 30 Balance on Goods Bal. on Curr. Acct. Bal. on Cap. Acct. - 50 5 5

9. U.S. Export Transaction U.S. Import Transaction Balance of Payments Flexible Exchange Rates The Market for Currency Determinants of Exchange Rates Fixed Exchange Rates Exchange Controls and Rationing International Exchange Rate Systems Recent U.S. Trade Deficits Key Terms Goods exports…………….. Goods imports…………….. + U.S. Goods export………………….…….…..+$100 - U.S. Goods imports…………………………….. - 80 + U.S. Service exports…………………………... +40 - U.S. Service imports………………………….… - 90 + Net Investment income………………..……….+20 - Net transfers………………………………….…. - 15 + Capital inflows to the U.S…………………..….+40 - Capital outflows from the U.S……………..…. - 10. - Official reserves ………………......................…. - 5 surplus $20 1. The U.S. is experiencing a balance on goods(deficit/surplus)of ($10/$20/$30 ). $100$80$20 Goods exports ($100) – goods imports ($80) = $20. deficit 2. The U.S.’s balance on goods and services is a (deficit/surplus) of $30 billion. $140$170-$30 (goods/services exports($140) – goods/services imports ($170) = -$30) -$25 3. The U.S.’s balance on the current account is (+25/-$25). (-$30)($20)(-$15)(-$25)]. [Balance on g/s(-$30) + net investment income($20) + net transfers(-$15)=C.A.(-$25)]. surplus 4. The balance on the capital account is a (surplus/deficit) of ($20/$30/$40). ($40)(-$10)$30 [capital inflow($40) – capital outflow(-$10) = $30] surplus 5. The U.S. is experiencing a balance of payments (surplus/deficit) of $5. [don’t include official reserves here] imported 6. The “official reserves account indicates the U.S. (imported/exported) $5 billion of its stock of foreign reserves. +exportenter [A + here means we will export a stock of foreign money($’s will enter U.S.] - import exit [A - here means we will import a stock of foreign money($’s will exit U.S.] 20 -30 G/S Curr.Acct - 25 30 Balance on Goods Bal. on Curr. Acct. Bal. on Cap. Acct. - 50 5 5

10. U.S. Export Transaction U.S. Import Transaction Balance of Payments Flexible Exchange Rates The Market for Currency Determinants of Exchange Rates Fixed Exchange Rates Exchange Controls and Rationing International Exchange Rate Systems Recent U.S. Trade Deficits Key Terms A Few notes on BOP If you look at the U.S. balance of payments or any other country you will see that the balance of the current account will offset the capital account, except for immaterial differences (ignore these, they are primarily timing differences). The reason is a logical and simple one: each country is unable to use the other countries currency and, thus, all each country can do is "trade". Using China as an example, the U.S. has a current account deficit (we buy more of their products & services than China does of ours), which puts China in a position of saying: "hmmm, what do I do with these worthless U.S. dollars?" Since China, by the fact of a U.S. current account deficit, did not spend the U.S. dollars we sent them on our own products/exports, and being the intelligent country that they are, China will always decide to "invest" or "save" their U.S. dollars via the Capital Account by using those same US dollars to invest in US financial assets (bonds, stocks, etc.), or real assets (land, US manufacturing plants, etc.) So whenever you buy those shirts from China you are helping to fund the U.S. Government's deficit spending and those same U.S. dollars you paid for the shirts will be flowing directly to an American company and worker making frisbees.

11. U.S. Export Transaction U.S. Import Transaction Balance of Payments Flexible Exchange Rates The Market for Currency Determinants of Exchange Rates Fixed Exchange Rates Exchange Controls and Rationing International Exchange Rate Systems Recent U.S. Trade Deficits Key Terms Said another way: The U.S. currently has a large current account deficit with China (we're buying, net, more of their products & services than vice versa). China (businesses, households, government) has willingly elected to save many of the U.S. dollars we sent them for their products. Since China is an intelligent country, they will, through self interest, create a capital account surplus to the U.S. by saving those same U.S. dollars (sent to them for their products) by investing them in U.S. financial assets (U.S. bonds, U.S. stocks, U.S. saving accounts, etc.) or use those same US dollars to build U.S. plants or buy land in the U.S. The opportunity cost would be high for China to just to just hold those U.S. dollars in a mayonnaise jar or use them for kindling to start their fires. Said another way, "trade" is really trade like the early settlers did since countries cannot use the other country's currency so they are forced to immediately spend it back into the originating country. In the case of China, they are temporarily saving the U.S. dollars they received for their products, but will ultimately spend them back into our economy. One interesting thought, is everytime an American buys a shirt from China you are actually funding American jobs as well, which is why trade is always the way to go. In the case of China, the prevalent scenario is the US dollars spent for the Chinese shirt (U.S. import) is being lent back to the US Government (due to deficit spending) to returf the lawn on the Mall! Trade is trade and is always balanced (current account = capital account). The only question is what is being traded.

12. U.S. Export Transaction U.S. Import Transaction Balance of Payments Flexible Exchange Rates The Market for Currency Determinants of Exchange Rates Fixed Exchange Rates Exchange Controls and Rationing International Exchange Rate Systems Recent U.S. Trade Deficits Key Terms Flexible Exchange Rates Two Systems: 1) Flexible or Floating- Exchange-Rate System- demand and supply determine exchange rates, not govt. 2) Fixed Exchange-Rate System- govts. Determine exchange rates and make adjustments in their economies to maintain those rates.

13. U.S. Export Transaction U.S. Import Transaction Balance of Payments Flexible Exchange Rates The Market for Currency Determinants of Exchange Rates Fixed Exchange Rates Exchange Controls and Rationing International Exchange Rate Systems Recent U.S. Trade Deficits Key Terms DISADVANTAGES OF FLEXIBLE EXCHANGE RATES Uncertainty and Diminished Trade Terms of Trade Changes Instability of a Country’s Currency

14. U.S. Export Transaction U.S. Import Transaction Balance of Payments Flexible Exchange Rates The Market for Currency Determinants of Exchange Rates Fixed Exchange Rates Exchange Controls and Rationing International Exchange Rate Systems Recent U.S. Trade Deficits Key Terms FIXED EXCHANGE RATES Use of Reserves Currency Interventions Trade Policies

15. U.S. Export Transaction U.S. Import Transaction Balance of Payments Flexible Exchange Rates The Market for Currency Determinants of Exchange Rates Fixed Exchange Rates Exchange Controls and Rationing International Exchange Rate Systems Recent U.S. Trade Deficits Key Terms EXCHANGE CONTROLS & RATIONING Distorted Trade Favoritism Restricted Choice Black Markets

16. U.S. Export Transaction U.S. Import Transaction Balance of Payments Flexible Exchange Rates The Market for Currency Determinants of Exchange Rates Fixed Exchange Rates Exchange Controls and Rationing International Exchange Rate Systems Recent U.S. Trade Deficits Key Terms INTERNATIONAL EXCHANGE- RATE SYSTEMS The Gold Standard: Fixed Exchange Rates 1879 - 1934 Devaluation The Bretton Woods System IMF - Pegged Exchange Rates Official Reserves Gold Sales IMF Borrowing Managed Floating Exchange Rates G-8 Nations Interventions